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Dividend-Paying Stocks: The Legend, the Myth

Authors Linda Palonen and Frank GarciaThere is a myth that is pervasive in the investment industry that most historical investment gains are attributed to dividends and the stocks that pay them. If this were true you could make a case for owning only dividend-paying stocks. Some Wall Street pundits promote this strategy. However, there are reasons why RCG portfolios include both dividend-paying stocks and non-dividend-paying stocks.

What is a dividend?

A dividend is a taxable distribution of a company’s earnings to its shareholders. Apple, for example, paid a dividend last quarter of 57 cents per share, meaning that every shareholder received a cash distribution of 57 cents for every share they owned. That may not seem like much, until you realize that Apple had 5.4 billion shares outstanding as of July 2016. Simply multiplying that measly 57 cents by the 5.4 billion shares outstanding reveals that Apple paid over $3 billion in dividends last quarter alone!

Are dividends dependable?

A common misconception about dividends is that they are “guaranteed income.” This could not be further from the truth, as dividends are reduced or even eliminated by companies occasionally. A reduction or elimination of dividends tends to happen at the worst possible time for investors seeking the safety and security of “guaranteed income.” In 2009, the year after the global financial crisis, 57% of dividend-paying firms either reduced or eliminated their dividends. So much for that guarantee.

Do all companies pay dividends?

Whether to pay a dividend is entirely at the company’s discretion. The same goes for increasing (or reducing) a dividend. At the end of 2015, about 64% of stocks globally paid dividends. This amount varies widely from country to country. For example, 92% of Japanese publicly traded companies paid dividends while only 44% of Australian companies paid dividends. In comparison, 52% of US-based companies paid dividends. Reasons for these global differences include the tax treatment of dividends, industry concentrations of publicly traded companies within a country, investor preference for dividends, and the average size of publicly traded companies.

Dividend distributions are only one of the many ways that companies can return capital to shareholders. Another alternative is through share buybacks, which are more popular than ever. In the early 1980’s, share buybacks accounted for less than 10% of all capital distributed to shareholders. Today share buybacks account for 50% to 60% of capital that is returned to shareholders. Considering dividends solely doesn’t provide an investor with the full picture of how a company can increase shareholder wealth.

Should I buy dividend-paying or non-dividend-paying stocks?

This is a question we encounter frequently. Compare the performance of dividend-paying stocks vs. non-dividend-paying stocks for the last 25 years.

Returns in USD 1991-2015: Global equity dividend payers vs. non-payers

Dividend-paying stocks Non-dividend-paying stocks
Annualized Compound Total Return 7.77% 8.38%
Annual Standard Deviation 16.27% 26.24%

From a total return standpoint, the data suggests that an investor should only purchase non-dividend-paying stocks. However, take note of the difference in standard deviation, which is a measurement of risk, between dividend and non-dividend stocks. Why do non-dividend-paying stocks outperform dividend-paying stocks? Why are non-dividend-paying stocks so much riskier?  Look at the size of companies that tend to pay dividends.

Large-Cap Vs. Small-Cap

Percentage of Companies Globally Paying Dividends

This chart shows the percentage of companies globally that paid dividends from 1991-2015. The blue line represents the entire market; the green and orange lines represent large- and small-cap companies respectively. Once you separate the market into large companies and small companies, you see that globally, 85% of large-company stocks pay dividends, while only 57% of small-company stocks do.

Large companies, with more stable cash flows and more predictable business cycles, are more likely to pay dividends. Smaller companies generally have less predictable earnings and cash flows, and often prefer to reinvest profits into growing the business, and are therefore less likely to pay dividends.

What does this mean for my portfolio?

If you only invest in dividend-paying companies, you immediately remove 36% of globally listed stocks from your investment universe. You also severely limit your ability to invest in small-cap companies. Historically, both small-cap stocks (which are less likely to pay dividends) and value stocks (which are more likely to pay dividends) have performed better than the overall market. Thus, the market data suggests that investors should own both dividend-paying stocks and non-dividend-paying stocks.

Because of this, we include both dividend and non-dividend stocks in our portfolios. Approximately 80% of the stocks held through various mutual funds in RCG’s investment portfolios pay dividends, while 20% do not. The 20% that don’t pay dividends tend to be smaller or less mature companies that can increase a portfolio’s expected return through capital appreciation.

The definition of a myth is “a widely-held but false belief or idea.” The philosophy that it’s best to own only dividend-paying stocks is therefore a myth. Once you learn the whole story, you realize that while dividend stocks are a valuable component of a well-diversified portfolio, to own them exclusively would lessen the chance of a successful investing experience.

This article uses a historical database of international equity securities constructed from data provided by Bloomberg and Dimensional Fund Advisors (DFA) and focuses on 23 developed market countries. The countries are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the Netherlands, the United Kingdom, and the United States, PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. The index returns above assume reinvestment of all distributions. This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale.